TOPIC 6

COST OF CAPITAL
 CONTENTS

1. Concept: Cost of capital

2. Determining individual costs of capital

 Cost of debt
 Cost of preferred stock
 Cost of common stock

3. Weighted Average Cost of Capital (WACC)

CONCEPT: COST OF CAPITAL

 Cost of capital is the rate that must be earned on an

investment project if the project is to increase the value of the
common stockholder’s investment.
 Investor’s required rate of return is the minimum rate of
return necessary to attract an investor to purchase or hold a
security.
 Cost of capital is not the same as investor’s required rate of
return because of:
a. Taxes
b. Floatation costs
CONCEPT: COST OF CAPITAL

a. Taxes
 When a firm borrows money to finance the purchase of
an asset, the interest expense is deductible for federal
income tax calculation (interest payment from bond or
debt financing is tax deductible).
 Consider a firm that borrows at 9% (required rate of
returns) and then deducts its interest expense from its
revenues before paying taxes at a rate of 34%
 After-tax cost of debt = 9% (1-0.34) = 5.94%
 No tax deductible effects on Common Stock and
Preferred Stock.
CONCEPT: COST OF CAPITAL

b. Floatation costs
 Flotation cost is the total cost incurred by a
company in offering its securities to the public.
They arise from expenses such as underwriting
fees, audit fees, accounting fees, legal fees and
registration fees.
 In the securities industry, underwriting fees are
the fees earned by an investment bank to help
bring a company public or to conduct some
other offering.
CONCEPT: COST OF CAPITAL

b. Floatation costs
 Flotation cost is defined as the cost incurred by the company
when they issue new stocks or bonds or preferred stock in the
market as the process involves various stages and participants.
 It includes audit fees, legal fees, accounting fees, investment
bank’s share out of the issuance and the fees to list the stocks on
the stock exchange that needs to be paid to the exchange.
 It is evident that due to this cost that is involved in the issuance
of the new stocks, the final price of the new stocks is reduced
and ultimately results in a lowered amount of capital that can be
raised.
 The cost involved in the issuance of debt securities (bonds) or 
preferred stocks is often less than issuing common stocks.
CONCEPT: COST OF CAPITAL

 It is possible to finance a firm entirely with common

equity. However, most firms employ several types of
capital components which includes debt, preferred
stock and common stock.

 A firm’s weighted cost of capital is a function of

a. The individual cost of capital
b. The capital structure mix
c. The level of financing necessary to make the investment
DETERMINING INDIVIDUAL
COSTS OF CAPITAL
 The required rate of return on each capital component
is called individual costs of capital. It consists of
a. Cost of debt
b. Cost of preferred stock
c. Cost of common stock

 The cost of capital of each securities is equal to the

investor’s required rate of return after adjusting for
the effects of both floatation costs and corporate taxes
COST OF DEBT (Kd)
 Cost of debt is the after-tax cost of debt
 For the issuing firm, the cost of debt is:
• The required rate of return by investors (Kd)
• Adjusted for floatation costs (any costs associated with issuing new
bonds)
• Adjusted for taxes
 Cost of debt before tax (kd): => recall YTM formula in Topic 5
M - NP
I = interest
Kd =I+ n M = par value
NP = net price = MP – FC
M + NP n = maturity date
2
 Kd after tax = Kd (1 - tax)
 EXAMPLE
XYZ Berhad is issuing a RM1,000 par value bond that pays 8%
annual interest and mature in 10 years. Investors are willing to
pay RM950 for the bond. Floatation costs will be RM50 per unit.
The firm’s marginal tax is 35%. What will be the firm’s after tax
cost of debt on the bond?

I = 80 M = 1,000 NP = 950-50 = 900 n = 10 tax = 35%

1000 - 900
Kd = 80 + 10 = 9.47%
1000 + 900
2

Kd after tax = 9.47% (1-0.35) = 6.16%

 EXERCISE
1. A bond has a RM1,000 par value and coupon rate of 12%. A
new issue would net the firm 90% of the RM1,150 market
value. The bonds mature in 20 years, the firm’s marginal tax
rate is 34%. Calculate the cost of debt after tax.

2. Qaseh Berhad is issuing a RM1,000 par value bond that pays

7% annual interest and mature in 15 years. Investors are
willing to pay RM958 for the bond. Floatation costs will be
11% of market value. The firm’s tax bracket is 18%. Calculate
the cost of debt after tax.
COST OF PREFERRED STOCK (Kps)
 Cost of preferred stock(required rate of return on preferred
stock) = Kps

 Formula in calculating cost of preferred stock

Kps = Preferred stock dividend = Dividend
Net proceeds per preferred share MP - FC
MP = Market Price
FC = Floatation Cost
 No tax adjustment when calculating Kps.
 EXAMPLE
1. A preferred stock of XL Bhd sells for RM26.25 and pays
RM2.06 in dividend. If a new issue is offered floatation cost
will be RM2.00 per share. What is the cost of preferred
stock?
Kps = 2.06 / (26.25 -2)
= 8.50%

2. If FGS Bhd issues preferred stock, it will pay a dividend of

RM8 per year and should be valued at RM75 per share. If
floatation costs amount to RM1 per share, what is the cost
of preferred stock?
Kps = 8 / (75-1)
= 10.81%
 EXERCISE

Compute the cost of preferred stock:

1) A preferred stock paying a 7% dividend on a RM100 par
value. If a new issue is offered, the company can expect to
net RM85 per share

2) A preferred stock sells for RM35 and pays RM2.75 dividends.

The net price of the security after issuance cost is RM32.50